Buy v Rent, Part 2: ROI

In the earlier post, we looked at the total cost of accommodation, whether you make an outright purchase, pay via EMIs, or rent the property. In this post, we will look at the returns you can expect.

“Why” decides “how much”

The ROI you should expect depends on why you are investing in the property. 

To illustrate, if you are going to live in the property for a long time (read as anything longer than 10 years), then ROI isn’t the primary question. In such a case, the decision to buy will depend largely on the amenities you want and the price you can afford.

However, if the property is being purchased as a source of income or investment, then it must be compared with other investment options. We will explain this in the following sections.

What are you buying?

Two adjacent properties on the same street can fetch different returns. Without going into all factors, let us focus on a few key ones.

Location - Although riskier, a property in a developing part of the city will fetch greater returns than one in the heart of the city.

Ownership of land and age of property - Are you buying an independent house, and hence the entire land below it? Or are you buying an apartment in a huge gated community, and therefore at best* a fraction of the entire land? 

While the market value of land will increase, the value of the building will depreciate with each year. 

Tax deductions 

Under section 80C, buyers can claim tax deduction up to Rs. 1.5 lakhs on the principal and/or stamp duty along with registration charges. It must be noted that section 80C offers many other tax deductions, be it life insurance premium, payment of children's tuition fees, and investments like PPF, ELSS, NPS among others.

For interest paid on the home loan, Section 24 allows the owner to claim up to Rs. 2 lakhs for a self-occupied property and entire interest without any upper limit for a let-out property. In case of a joint home loan in which both own the property and pay EMIs, interest paid can be claimed as tax deduction for both.

However, given how EMIs are structured, the interest component keeps reducing with each month while the principal increases. On the other hand, your tax deductions for HRA will generally keep increasing as your salary increases. 

Rent vs EMI

The main financial reason for owning a home is that for a sum higher than rent, one can pay EMIs and own the property. Thus, by paying EMIs over a 20-year period, the owner would have a property completely paid for while the tenant (or renter) would only have the money saved from paying the rent.

How is the market?

In usual times, trying to answer this question can be a futile exercise. However, the real estate slump coupled with the impact of Coronavirus has led to demand drying up. Even as the unsold inventory of apartments across the country is bankrupting developers and choking the banking sector, prices haven't fallen as expected.

Many who bought properties in urban areas around 2005 have seen a 10x price appreciation, an ROI that easily beats the Sensex. But due to the real estate slowdown, buyers now will have to settle for a lot less, at least in the short-term. While nobody can predict prices in 2040, it is better to be prepared for 5% annual returns while hoping for 10%. 

In the following examples, we will be projecting ROI based on this conservative return of 5% per annum.

Until recently, Chennai was among the cities which saw double-digit growth in real estate prices. 

The impact of EMI:Rent ratio

As we explained in the earlier post, your EMI shouldn’t be more than 60% (a ratio of 1.6) than the rent. We will take a look at the five properties and see what would be the impact of EMI:Rent ratio.

Just to recap, we are considering these options of living in a property-

Option 1) Owning it by paying the entire amount in one go, i.e. outright purchase. The ROI will be the price appreciation with or without the rent. The rent earned is invested at 9% per annum.

Option 2) Paying a rent that increases by 5% every year. The ROI will be investing the remaining amount (EMI minus Rent) for 9% returns.

Option 3) Owning it by paying only 20% as down-payment and repaying the remaining 80% as EMIs at 9% interest for 20 years. The ROI will be simply the price appreciation.

Assumptions - rent & price to increase at 5%, EMI @ 9% for 20 years, investment to grow at 9%

Using the table below, let us study the impact of this ratio in each scenario. For each property, compare the highlighted column with the ROI for each of the three options. What do you observe?

Table 1 - Impact of EMI: Rent ratio on ROI

All figures in lakhs

To see the complete calculations, please go through this spreadsheet.

Observations

Option 1 - Outright purchase

Since the highest returns are for where the ratio is the least, buy a property when the ratio is 1.6 or less. Please see the returns for properties B and D, ratio of 1.53 and 2.32 respectively.

Option 2 - Renting the property and investing the difference

This option makes sense if the EMI is much higher than the rent, i.e. a high ratio. For properties A, C, and E, this difference is more than the price appreciation (Column 3).   

Option 3 - Owning and living in the property after paying EMIs

Since there is no rent, the IRR after EMIs is the same irrespective of EMI:Rent ratio. The ROI or EMI depends only on two factors - home loan rate and price appreciation. Since price appreciation has a bigger role, you should take a loan and buy a property if you expect the price to go up significantly in the long run.

Secondly, the EMI-Rent ratio will come into play if you rent out the property at some point.

Checklist: so, should you buy or rent?

By answering these questions in the given order, you should be able to decide.

1. Will you live in the property long enough, be able to afford the cost, and get a good sale price, i.e. a price greater than your cost incurred? If yes, buy it.
2. If not, do you believe the property will be a better investment (rent and/or price appreciation) than other investing options? If yes, buy it.
3. If not, do you believe that the EMI is very close to the rent, i.e. no more than 1.6 times, and you will live in the property for 4-5 years? If yes, buy it. Otherwise, you are better off renting it.

Final Thoughts

1) If you intend to live in the property, you should ask - will it be an affordable and good enough place to live? If yes, only then should you consider its ROI.

2) If you intend to buy it purely for investment, you should remember that real estate has some inherent drawbacks not seen in other assets.

Be it encroachment by squatters, legal disputes, acquisition by government for public interest projects, missing paperwork, violations in construction, difficult tenants, or having to deal with black money, an investment in real estate may see problems not seen with other assets. Some of these have been explored in Hindi movies like Kirayadar (1986), Khosla ka Ghosla (2006), and movies in other Indian languages.

3) As personal finance experts like Robert Kiyosaki (Author of Rich Dad, Poor Dad) and others have said, most wealthy individuals made money in stocks and the market, not real estate. 

4) If you do choose to invest in real estate, you should evaluate it on the same criteria as you would do for any investment.

5) As a rule of thumb, a property should offer you 4% rental yield. In other words, your annual rent should be at least 4% of the total cost of buying and maintaining the property. A good rental yield will be a good backup if the property price doesn't appreciate as expected. Secondly, you have greater control over the rental yield as compared to the market price of your property.

6) The ROI for Option 1 (Outright Purchase) and Option 2 (Renting) look good because the extra money or income fetches an interest at 9%, which is re-invested. If the money doesn’t grow at greater than 9% or get re-invested, the ROI will come down significantly.